- Cisco Systems designs, manufactures and sells IP-based network solutions, products, and related services, which are at the heart of the growing IoT revolution.
- Cisco operates in a somewhat mature market, but the launch of 5G networks and Cisco's change in business strategy with "Silicon One" could reignite growth.
- Even with slow or no real revenue growth, Cisco continues to generate robust free cash flow, which will allow dividends and buybacks to continue to rise.
- Cisco is grossly undervalued after the sell-off in March. I rate Cisco as a conviction buy at the current price of $41 for DG investors.
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After the recent sell-off (to put it lightly), Cisco (NASDAQ:CSCO) has come to trade at a level where long-term dividend investors can add it to their portfolios with conviction. At $41 a share (and a 3.45% dividend yield), Cisco’s stock is grossly undervalued, as I will demonstrate later in this article.
Since Cisco is seen as something of a bellwether for global economic trends, it's justifiably being substantially discounted; however, the pessimism priced into the stock is excessive and has created an opportunity to generate solid returns. However, to be clear, I don't view these returns as blockbuster by any means, but they're rather secure. Further, the company yields a solid 3.45% dividend, and I am all about catering to dividend growth investors as much as I am about catering to high growth investors.
To be sure, Cisco’s revenue growth is projected to be underwhelming yet again; however, there's hope yet on the horizon! I've predicated my investment thesis contained herein on a few factors:
- 5G technology’s official arrival (which will entail an uptick in routing & switching device demand),
- Cisco’s network disaggregation (hardware and software independence), and
- Adoption of a subscription model for its software & services.
Even with insignificant growth over the last decade, Cisco has managed to enhance shareholder value via stable, rising dividends (9 years running heretofore) and stock buybacks. Cisco’s market leadership and financial strength should enable it to continue in this vein for the foreseeable future.
To put it concisely, I view Cisco as a fantastic opportunity for investors who strive for a robust, consistently growing dividend income (from the first day of purchase) with the potential for long-term price appreciation.
Outline of Today's Research Note
- Cisco: Business Overview
- A look into Cisco’s financials
- Estimation of a fair value for Cisco’s stock
- Final recommendation on Cisco
Let's get started!
Cisco: Business Overview
Cisco Systems touts itself as the worldwide leader in IT, networking, and cybersecurity solutions. The company’s core business comprises the design and manufacturing of networking hardware, related software solutions, IT services, and cybersecurity. Despite the immense expansion of SaaS (software as a service) and the development of cloud computing, Cisco’s major revenue source is still largely its legacy hardware (routing and switches) unit that contributes to ~75% of its total revenues.
As can be seen in the chart above, Cisco commands nearly ~48% market share of the worldwide routing and switches market, the growth of which is not incredible, but still steady. With the advent of 5G technology and augmented reality more broadly, the number of connected IoT devices across the globe is set to explode. According to Statista.com, there were 26.66 billion connected IoT devices across the globe in 2019, and this figure is set to rise to 75.44 billion by 2025!
For all these devices to communicate with one another (which is the central idea of the Internet of Things), the need for network equipment is going to balloon. The expected growth for routing and switches market is 7% CAGR between 2019 and 2023. Cisco envisions using 5G’s capability (low latency - 1GB/s) to replace legacy wired access networks (WAN). Such an application of 5G could revolutionize business and residential wired internet services. Also, data centers will require new technologies like 400G to tackle the impending data boom.
For those of you with Dotcom bubble PTSD, yes, Cisco is yet again on the precipice of capitalizing massive new developments in the way humans exist... But this time, the company does not trade at 40x sales. Instead, it trades at about 3.4x sales, a significantly more reasonable valuation.
Cisco's Disco With 5G (And Other Growth Catalysts)
Cisco is at the forefront of 5G innovation among network equipment manufacturers, and it is expected to win the majority of the market share in North America. Cisco will face stiff competition from Huawei, but there's such a massive market for Cisco and Huawei's products that they will both be able to eat. Thus, 5G could be a huge catalyst for accelerated growth at Cisco. Further, WiFi 6 (new WiFi internet standard) and 400G (data center) are other potential growth drivers in play at Cisco.
As I mentioned earlier, the network equipment market is mature, and growth rates are in the mid-single digits. Cisco understands this, and in response, the company has taken action to diversify its revenue stream away from its legacy hardware offerings. We will explore this in more detail when we study its revenue trends in the next section.
Cisco’s acquisition of companies like Jabber, OpenDNS, Jasper, and Webex has enabled the company to become a specialist in specific technology markets, such as the Internet of Things (IoT), energy management, and domain security.
With this foundational knowledge of Cisco’s present business in mind, let's now dig into its financials. In doing so, we will answer two questions:
- Is Cisco under or overvalued?
- What should we expect in the way of future returns from purchasing Cisco today?
A Look Into Cisco’s Financials
Before analyzing the income statement, I'd like to share Cisco’s price chart with you. Cisco has delivered price returns of only 4.8% CAGR over the last ten years, making it a significant underperformer in comparison to the S&P 500.
Now, you might be thinking, if Cisco is such an underperforming stock, then why is it being recommended as a buy? Valid question. A detailed financial statement analysis, in combination with vital information on potential growth drivers, provides us the answer to your question.
Income Statement Analysis
By this point in the analysis, I usually diverge into strictly numbers, but Cisco's income statement must be annotated, as after we just discussed its massive market opportunities, it's difficult to reconcile flattening revenues with massive market opportunities... So let's check it out.
As can be seen above, Cisco sports gross margins of 64%. Higher gross margins indicate that Cisco’s products and services are differentiated and highly valued by its customers. Companies that sell products with extremely low gross margins, such as Exxon Mobil (XOM) or Chipotle (CMG), produce products in markets that have low barriers to entry, and therefore, these companies cannot command pricing power. Cisco's margins demonstrate that, despite rampant competition in its sector, it remains one of the stalwart leaders in the industry.
Gross margins have gone up in the last five years, which is positive, but on the other hand, revenue has flattened. Such a pattern is not a great sign for the business and indicates something is hindering the company’s growth (spoiler alert: it's managerial execution).
Upon further investigation, I discovered that Cisco has been losing market share across the board due to some of its significant customers like AT&T (T) choosing more affordable generic “white-box” routers and switches for its network.
Traditional companies still depend on Cisco’s products, but disruptive cloud titans like Facebook (FB) strongly advocate disaggregation of networks (i.e., hardware and software are independent). Up until 2018, Cisco used to package its hardware and software offerings (upselling), and this unwanted dependency led to losses in market share to its more flexible rivals like Arista (ANET), Juniper (JNPR), and Huawei.
So, what has management done to address these issues borne out by the income statement? For a start, Cisco’s management opted to modify its business strategy. The company is now implementing a plan to disaggregate dependencies of its hardware on proprietary software (e.g., “Cisco Silicon One”).
Simultaneously, Cisco has been preparing for the future by reinvesting a considerable chunk of its cash flows into R&D, which it projects will embolden its software and services offerings. The results of such a strategy can be seen below:
Source: Cisco 10-K
In 2019, while revenue from infrastructure platforms went up 7%, applications and security revenues rose by 15% and 16%, respectively. The higher rate of growth in non-core segments proves that Cisco’s diversification plan is working. Cisco has also been transforming its business strategy within the software, moving from perpetual to subscription revenues. In Q2 FY 2020, the revenue from subscriptions constituted 72% of the total software revenues.
With 5G devices and networks going live, Cisco’s significant investments in 5G may bear fruits shortly, in the form of increased revenues. Additionally, worldwide growth in IoT devices and increased focus on cybersecurity should serve as a critical driver of revenues going forward. Cisco is well-positioned to take advantage of these major technology trends, and the company should see accelerated revenue growth (i.e., mid to high single digits) over the next few years.
Balance Sheet and Cash Flow Analysis
Cisco is a conservatively managed company, as is evidenced by its balance sheet, the long-term debt of which declined by 6 billion dollars from 2018 to 2019.
Rising Dividends and Stock Buybacks
Cisco has massive leverage to enhance shareholder returns through the return of capital. Though I have serious apprehensions about management's ability to execute (due to IBM (IBM) PTSD, though I never owned IBM, and my current growing concern regarding Alphabet (GOOG) (GOOGL)), Cisco has been extremely shareholder-friendly.
In the last few years, Cisco repurchased around $50B worth of shares outstanding, which has reduced its massive cash reserves on the balance sheet. As of today, those buybacks have proven to have been extraordinarily ill-timed, but that's only positive for us. Any manager who thought they were going to max out their bonuses via buybacks will now have to work doubly hard, and continue to buy back shares.
Cisco started paying dividends in 2011; since then, the annual dividend per share has steadily increased from $0.12 to $1.36. In the same time frame, through large buyback programs, the company reduced its number of shares outstanding by ~20% from 5.563 billion to 4.453 billion. Cisco’s strong cash flow generation and balance sheet should enable it to continue growing its dividends in the short and long term.
Even in a recessionary environment, I fully expect Cisco to continue paying, as even in a worst case scenario of 30% or 40% revenue declines, the dividend will be very safe.
What Should I Pay For Cisco?
To find a fair value for Cisco’s stock as well as the returns one should expect from buying it, we will employ my proprietary valuation model. Here’s what it entails:
- Traditional discounted cash flow model using free cash flow to equity discounted by our (as shareholders) cost of capital.
- Discounted cash flow model including the effects of buybacks.
- Normalizing valuation for future growth prospects at the end of the ten years. (3a.) Then, using today’s share price and the projected share price at the end of 10 years, we arrive at a CAGR. If this beats the market by enough of a margin, we invest. If not, we wait for a better entry point.
Now, let’s check out the results.
L.A. Stevens Valuation Model
The L.A. Stevens Valuation Model answers two questions:
- Is the company under or overvalued?
- What should I expect in the way of future returns?
Free cash flow per share
Free cash flow per share growth rate
Terminal growth rate
Years of elevated growth
Total years to stimulate
Discount Rate (Our “Next Best Alternative”)
Using the L.A. Stevens Valuation Model, I determined that Cisco’s fair value is $65.69, i.e., the stock is currently “Undervalued” by 37.58%.
Source: L.A. Stevens Valuation Model
The expected CAGR on investment in Cisco for ten years at the current price of $41 is 9.89%, which is equivalent to our hurdle rate (9.8%, i.e., 90-year annualized return on S&P 500). But a 3.45% dividend yield increases the total return to approximately ~13.3% CAGR, which will actually grow even larger as the dividend continues to grow via modest organic growth from revenues and through share repurchases.
So you will find DCF calculations all over the internet and in many other articles here on Seeking Alpha, but those calculations do not define specifically where the share price will move, and as a result, what we can expect in the way of future returns from share price appreciation.
The L.A. Stevens Valuation Model streamlines the process of calculating share price appreciation (and ultimately determining expected returns) by automatically calculating current and future share prices based on the growth of free cash flow per share (which is what ultimately will drive a stock's price).
Here's the result:
Source: L.A. Stevens Valuation Model
- Therefore, if one were to buy at today’s price of $41, they should expect an annualized total return of about 13.3%, which is above our “hurdle rate,” which is our “next best alternative,” i.e., the 90-year annualized performance of SPY (9.8%).
Hence, I feel confident in recommending Cisco to long-term dividend investors at today’s price of $41, as this is a grossly undervalued stock with rock-solid dividends and potential for capital appreciation.
Cisco is a relatively high-tech company with rising dividends. We see revenues growing in mid to high single digits over the next five years due to a rise in global demand of Internet of Things (IoT) and 5G devices. With management’s continued motivation to return excess cash to shareholders, an investor can expect enhanced long-term returns. Moreover, the stock is highly undervalued at the current price. Thus, I recommend our readers looking for long-term dividend investments, with a potential for capital appreciation, to buy Cisco.
Key takeaway: “Buy” - Cisco Systems at $41.
Please feel free to provide your feedback in the comments section and share your thoughts on Cisco Systems!
As always, thanks for reading; remember to follow, and happy investing!
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This article was written by
Louis Stevens offers a proprietary approach to equity (stock) investing.
Employing his Four Foundational Investment Frameworks, Louis purchases industry-leading businesses that possess mountainous cash hoards, robust free cash flow generation, long runways for growth, and quality company cultures.
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